Every property in CA should have at least 1 ADU

29 Replies

Every SFR in CA should have at least 1 ADU. I'd even go as far as to say you are losing money every month by not having an ADU on your property. These new laws are only in effect till 2024. What's stopping you from adding an Accessory Dwelling Unit to your property?

I disagree if you are advocating a hands off ADU addition (use of GC, contractors, designer, etc). Doing the effort yourself likely only makes sense if you already have the skills or plan on doing more than one ADU addition (can leverage the learning on future ADU additions).

The appraisals in most markets are coming in greater than $50K below hands off construction costs. The financing typically does not present terms that are as favorable as purchase financing. The level of effort hands off is about the same as a rehab (BRRRR) with far more money required for the ADU addition. The ADU subtracts value from the existing unit by reducing either the yard or by consuming a garage (assuming not in current living space which would even more significantly reduce the cash flow). The under value as set by the appraisal implies that the investment capital is trapped until appreciation can surpass the negative position by at least 33% of the total value (assuming 75% LTV REFI). The initial cash flow goes to recover the negative position as set by the current value of the ADU. It is often years before there is any cash flow in excess of the negative position.

In most markets, the ADU addition is one of the worse RE investments. I can do a BRRRR, trap very little into my asset and have added value in excess of the costs (versus a hands off ADU typically adds value far less than the costs). I can do a turnkey investment and start far less negative than an ADU addition.

However, if you are referring to purchasing a unit with an existing ADU, this could provide a good value. The purchase would be at market based value of the ADU which in most markets if over $50K less than the hands off costs. The financing would be at purchase financing (typically superior to ADU addition financing). The cash flow would be similar to adding the ADU, but the costs would be substantially less.

Note, I also use the term "hands off".  If you are a developer, GC, a skilled worker with time to do significant amount of the work then these are different scenarios than the hands off scenario that I reference.

Anyone who wants to do add an ADU should start by understanding how the ADU will be valued for their property/market. If it is going to be valued significantly less than the costs (most markets), this initial negative position has to be factored into the decision. Recognize any negative position implies that the costs are trapped until appreciation provides the opportunity to extract any part of the ADU investment. Then look at the financing terms.

Virtually every COC calculation I have seen for ADU additions do not reflect the negative initial position and therefore are not accurate (or at least not an apples to apples comparison with COC calculations on most other investments).

Originally posted by @Pavan Sandhu :

Every SFR in CA should have at least 1 ADU. I'd even go as far as to say you are losing money every month by not having an ADU on your property. These new laws are only in effect till 2024. What's stopping you from adding an Accessory Dwelling Unit to your property?

The main things stopping me are that I don't know if I want to deal with 8 months worth of construction going on in my backyard and I'm also not sure if I want to have a tenant living on my property.  

Also, I think the points made by @dan Heuschele are spot on. For me, this would be a pure cash-flow play with diminished potential for LTCG...and I can think of better ways to achieve cash-flow without the added hassle and without the equity hit.

Dan those are some outstanding points you have indeed. The appraisal based on an ARV is tricky indeed but not impossible to navigate. Hard to calculate exactly how much an ADU would add to the traditional value of your property based on a traditional SFR appraisal. The Key is to get your SFR +ADU(1-2) valued like an MFR. Not easy to do but again doable. I've done it myself and have other case studies that have been able to as well.

Also agree being hands-off with your ADU is not the most financially feasible way to manage costs. But then again, You could have hundreds of thousands of dollars sitting in equity (Wasted Equity some may say); use that to build an ADU for yourself and the potential rental income would come from the main unit not the ADU. Short term rental gains will pay off ADU expense within a few years. How much and where you source the capital from will have a huge impact on the ADU choice. Best tip for your ADU to have the biggest financial impact is keep the scope small. 

Hands down a simple garage or basement conversion is the way to go. 


From what I'm seeing, there are only 2 reasons to do an ADU. Income or Family. Appreciation and the ability to pull money out via an increased ARV is just a bonus.

Overall agree with you Dan that's the trends in many cases but not every case. ADUs do pencil out but being hands-off is a recipe for higher costs. Hence 3d printed, pre-fabricated ADU models. Locality and access to great construction tradesmen is a big variant in costs as well.

Originally posted by @Pavan Sandhu :

Dan those are some outstanding points you have indeed. The appraisal based on an ARV is tricky indeed but not impossible to navigate. Hard to calculate exactly how much an ADU would add to the traditional value of your property based on a traditional SFR appraisal. The Key is to get your SFR +ADU(1-2) valued like an MFR. Not easy to do but again doable. I've done it myself and have other case studies that have been able to as well.

Also agree being hands-off with your ADU is not the most financially feasible way to manage costs. But then again, You could have hundreds of thousands of dollars sitting in equity (Wasted Equity some may say); use that to build an ADU for yourself and the potential rental income would come from the main unit not the ADU. Short term rental gains will pay off ADU expense within a few years. How much and where you source the capital from will have a huge impact on the ADU choice. Best tip for your ADU to have the biggest financial impact is keep the scope small. 

Hands down a simple garage or basement conversion is the way to go. 


From what I'm seeing, there are only 2 reasons to do an ADU. Income or Family. Appreciation and the ability to pull money out via an increased ARV is just a bonus.

Overall agree with you Dan that's the trends in many cases but not every case. ADUs do pencil out but being hands-off is a recipe for higher costs. Hence 3d printed, pre-fabricated ADU models. Locality and access to great construction tradesmen is a big variant in costs as well.



>The Key is to get yourSFR +ADU(1-2) valued like an MFR.

The location definitely is a big factor with the associated value of the ADU addition, but even when the ADU is valued similar to duplex to quad additional units it is challenging to get full hands off costs as set by an appraisal.  This was true prior to the lumber price explosion, but more true now that plywood and OSB have risen close to 300% and other lumber costs have risen substantially.

BTW it is my belief that an ADU should never be appraised similar to a permitted extra duplex to quad, non-ADU, unit in CA.  Here is some of my reasons:

  • ADUs are not allowed to be used for STR.  Units in duplex to quads are allowed to be STRs in most areas in CA (not counting areas where STRs are banned in general).
  • If I have a duplex to quad, I can add ADU(s).  If I have a SFR and I have already added an ADU, with current rules I cannot add another ADU (not counting JADU which must come from existing living space).

I do recognize that ADUs are valued as additional MFR units in some locations whether I agree or not that this should be the case. This (ADU being appraised as an addition MFR unit) does reduce the initial negative position significantly, but typically still starts with a negative position (again I am only referring to hands off ADU additions, I know some developers that can ADUs with the ADU being a value add). It also still leaves the less than ideal financing. It still leaves that even hands off ADU additions involve quite a bit of effort. It still leaves that the ADU typically consumes either a yard or garage and often can affect privacy/livability.

To me it comes down to if I consider a hands off ADU addition the best investment for my assets. In virtually every case I believe there are better investment opportunities, including better RE investment opportunities, than a hands off ADU addition.

Before adding an ADU, determine the value that it will add to determine the initial negative position. This exercise is critical to having an accurate pro forma and should be a key component in determining if an ADU addition is the best investment option. After determining the value of the ADU addition, look at the financing, detraction from existing unit(s), and effort involved. If the analysis shows the ADU addition is a good investment after fully analyzing all aspect then great, but this will not be the case in many/most markets.

@Pavan Sandhu our ADU only adds $25k-$30k in value (1 bed; 1 bath 640 sq ft) on a property that is worth $300k (2 bed; 1 bath 976 sq ft). However, the ADU rents at $1150 while the main house rents at $1400. I don't get it. We did not build the ADU but I would only build one on very expensive dirt where rent is very high (ie So-Cal) due to current appraiser practices. It doesn't make sense from a balance sheet perspective that's for sure.

@Brian G. indeed rental demand is huge! COC return is quite amazing right? $1150 a month. How many months till you break even (i.e cost to build ADU) after that infinite ROI. Apprasied value is just a bonus. Rental income is the big win. You could always get an income based appraisal by using the two inked lease agreements for an higher mortgage cash out loan.

Originally posted by @Pavan Sandhu :

@Brian G. indeed rental demand is huge! COC return is quite amazing right? $1150 a month. How many months till you break even (i.e cost to build ADU) after that infinite ROI. Apprasied value is just a bonus. Rental income is the big win. You could always get an income based appraisal by using the two inked lease agreements for an higher mortgage cash out loan.

The flaw on COC calculations on ADU additions is they do not take into account the negative position.

Let's say I purchase a $600 duplex at 80% LTV (so $120k invested not including closing). Any cash flow is appropriately applied because the asset is worth what I paid for it.

Now let's say, with the current lumber price increases, you can do a nice garage conversion ADU addition for $120k, but the value of that conversion is $50k (which is greater than Brian indicates his ADU was valued). Let's say it rents for $1150 and being in a righ rent market we use 40% expense ratio (instead of the 50% rule). So a positive cash flow of $690. What is the COC? Most finance people that look at this would say it is zero. Why? Because for 101 months the cash flow goes to recover the negative position (negative $70k position). There is zero COC when there is a negative position. You do not just magically ignore the negative position.

Brian did awesome. By purchasing an existing ADU at a value of $30k that has zero negative position, his cash flow is correctly applied to his COC. If his expenses (not including P&I) are 40%, he has $690/month cash flow minus P&I (P&I on $30k conventional 30 year financing is virtually zero) on a $30k investment. He financed it with the same terms as the property purchase (typically the best, or near best, financing available). Someone else did all the work/effort of the ADU addition; even "hands off" ADU additions involve effort. He is lamenting the poor appraisal associated with the ADU, but the low value of the ADU allowed him to purchase the existing ADU at such a great value.

So the question is why add an ADU as an investment when you could purchase a property with an existing ADU for less than the cost of the ADU addition? You typically will receive better financing when purchasing the existing ADU. In addition, purchasing the existing ADU involves less effort than even a hands off ADU addition.


  

Sure @Dan Heuschele  you can't ignore but "initial negative cash position" i.e Down payment required to purchase.

But you do have to consider the cost of living. For owner-occupied situations, it's much easier to justify the initial negative cash position. Also, I would challenge the expense ratio. Especially for any conversions or additions. A Tight building envelope, all-electric appliances and low maintenance yard would make the expenses much more minimal. Again, biggest expense for most people is their living expense, so if by adding an ADU you reduced your living expense it would further make the initial negative position justifiable.

BUT Where I agree most with you is in the hands-off vs hands-on element. Very difficult to make an ADU build-out financially feasible if you can't value engineer the project yourself. The financing means you use will ultimately have a huge impact on ROI. Short-term ADU ROI may not be great but within a few years, the ROI truly is endless once you recoup your initial investment. It's also much easier to focus on a property you already have than find and secure a new property. At least for people without access to significant capital in CA markets. The ADU opportunity is essentially FREE LAND in CA for all homeowners. Yes, you need the rental demand and hundreds of other factors but i'd say MOST homeowners can justify an ADU.

Originally posted by @Pavan Sandhu :

Sure @Dan Heuschele you can't ignore but "initial negative cash position" i.e Down payment required to purchase.

But you do have to consider the cost of living. For owner-occupied situations, it's much easier to justify the initial negative cash position. Also, I would challenge the expense ratio. Especially for any conversions or additions. A Tight building envelope, all-electric appliances and low maintenance yard would make the expenses much more minimal. Again, biggest expense for most people is their living expense, so if by adding an ADU you reduced your living expense it would further make the initial negative position justifiable.

BUT Where I agree most with you is in the hands-off vs hands-on element. Very difficult to make an ADU build-out financially feasible if you can't value engineer the project yourself. The financing means you use will ultimately have a huge impact on ROI. Short-term ADU ROI may not be great but within a few years, the ROI truly is endless once you recoup your initial investment. It's also much easier to focus on a property you already have than find and secure a new property. At least for people without access to significant capital in CA markets. The ADU opportunity is essentially FREE LAND in CA for all homeowners. Yes, you need the rental demand and hundreds of other factors but i'd say MOST homeowners can justify an ADU.

 >For owner-occupied situations, it's much easier to justify the initial negative cash position.

I fear it is because they are less experienced investors and do not understand the impact this negative position has on the return or the potential growth.  Growth is typically best achieved by minimizing that capital trapped in an investment.  This negative position traps the capital for an extended period of time. 


>I would challenge the expense ratio.

40% expense ratio on small unit count (i.e. 2 in this case) is not conservative.  Have you figured a cap ex on a kitchen?  How about a water heater?  Add in maintenance, vacancy, I always include PM because I am either doing the role and deserve to be paid for my effort or I pay someone else to do it, taxes (note initial taxes are ~10% ratio on a 1% rent ratio (1.2% property tax rate), so 25% of the total of the 40% expense ratio is a certainty on a 1% rent ratio property (10% out of the 40%)), insurance, and Miscellaneous expenses.  You can challenge it, but there is a reason for the 50% rule.  I cut the 50% rule by 20% (20% of 50 is 10) for the high rent market, the reduction in costs of having 2 units co-located, etc.  I suspect the 40% expense ration will be fairly accurate in most high rent, low vacancy markets for the ADU.  For me to go lower than 40% expense ratio, I would need to analyze the property on an individual basis (does it have a yard, is it attached, how much hardscape, etc.).  I suspect that best case property will not be much lower than 40% expense ratio on a 2 unit count.

Use 40% expense ratio if you are low vacancy high rent market and do not want to be conservative.  Use 50% in most markets that do not have high HOA fees (i.e. do not have a lot of features such as pool, gym, etc).  Use greater than 50% expense ratio for feature laden HOA properties.  Again this is all low unit count properties.  The 50 unit, bare bones apartment building will have much lower expense ratio.




I'll post a few ADU case studies to outline how the COC returns make an ADU ideal. People want more cash flow. This initial negative cash position won't last very long. Only until they refinance. Now opportunity cost in-between time sure but for most people it's easier to work on property you already have rather than go source, finance and secure another property.

Indeed the value an ADU can add to a property is location-based, similar to any regular addition. In the Bay Area, as long as you don't overbuild, the value you add can easily exceed the construction cost - there are enough comps with ADUs on the market now it's easy to search on Redfin and Zillow. However, in Portland or other lower cost areas, most likely constructing an ADU will start you with a negative position.

Originally posted by @Pavan Sandhu :

Every SFR in CA should have at least 1 ADU. I'd even go as far as to say you are losing money every month by not having an ADU on your property. These new laws are only in effect till 2024. What's stopping you from adding an Accessory Dwelling Unit to your property?

This has been bugging me since a month or so - as people I know who are house hunting since an year , dont even view a property with backyard which can house an ADU as advantage, They are paying 900$ per sq ft but dont understand how creating additional 800 sq ft would add value . I am not familiar with California market so I just thought there is something that I dont know

Originally posted by @Dan Heuschele :
40% expense ratio on small unit count (i.e. 2 in this case) is not conservative.  Have you figured a cap ex on a kitchen?  How about a water heater?  Add in maintenance, vacancy, I always include PM because I am either doing the role and deserve to be paid for my effort or I pay someone else to do it, taxes (note initial taxes are ~10% ratio on a 1% rent ratio (1.2% property tax rate), so 25% of the total of the 40% expense ratio is a certainty on a 1% rent ratio property (10% out of the 40%)), insurance, and Miscellaneous expenses.  You can challenge it, but there is a reason for the 50% rule.  I cut the 50% rule by 20% (20% of 50 is 10) for the high rent market, the reduction in costs of having 2 units co-located, etc.  I suspect the 40% expense ration will be fairly accurate in most high rent, low vacancy markets for the ADU.  For me to go lower than 40% expense ratio, I would need to analyze the property on an individual basis (does it have a yard, is it attached, how much hardscape, etc.).  I suspect that best case property will not be much lower than 40% expense ratio on a 2 unit count.

Dan, in Los Angeles, a 40% expense ratio on a newly built or newly converted ADU is insane.

In my neighborhood, a 400-sq-ft garage converted to a studio would easily rent for $1800/month. Underwriting $720/month for expenses is way, way off. Capex on the kitchen and water heater? Neither need to be replaced for a decade. What will it cost to replace them? Let's generously say $20K. That's $167/month in capex reserves -- and that's if you're holding the property in a decade.

ADUs are most needed, and most financially rewarding, in CA's high-density cities.

Love your posts, by the way!

Jon

Originally posted by @Jon Schwartz :
Originally posted by @Dan Heuschele:
40% expense ratio on small unit count (i.e. 2 in this case) is not conservative.  Have you figured a cap ex on a kitchen?  How about a water heater?  Add in maintenance, vacancy, I always include PM because I am either doing the role and deserve to be paid for my effort or I pay someone else to do it, taxes (note initial taxes are ~10% ratio on a 1% rent ratio (1.2% property tax rate), so 25% of the total of the 40% expense ratio is a certainty on a 1% rent ratio property (10% out of the 40%)), insurance, and Miscellaneous expenses.  You can challenge it, but there is a reason for the 50% rule.  I cut the 50% rule by 20% (20% of 50 is 10) for the high rent market, the reduction in costs of having 2 units co-located, etc.  I suspect the 40% expense ration will be fairly accurate in most high rent, low vacancy markets for the ADU.  For me to go lower than 40% expense ratio, I would need to analyze the property on an individual basis (does it have a yard, is it attached, how much hardscape, etc.).  I suspect that best case property will not be much lower than 40% expense ratio on a 2 unit count.

Dan, in Los Angeles, a 40% expense ratio on a newly built or newly converted ADU is insane.

In my neighborhood, a 400-sq-ft garage converted to a studio would easily rent for $1800/month. Underwriting $720/month for expenses is way, way off. Capex on the kitchen and water heater? Neither need to be replaced for a decade. What will it cost to replace them? Let's generously say $20K. That's $167/month in capex reserves -- and that's if you're holding the property in a decade.

ADUs are most needed, and most financially rewarding, in CA's high-density cities.

Love your posts, by the way!

Jon

>in Los Angeles, a 40% expense ratio on a newly built or newly converted ADU is insane.

I disagree.  

I would have twice the life span on the kitchen and therefore half the cost, but that is just one item ($50 to $70 per month for the kitchen).  Water heater I use 12.5 years ($10 to $12 per month).  There are a lot of items and their maintenance and cap ex add up.    Have you filled out a detailed cap ex worksheet?

The prop tax alone starts at ~10% expense ratio by itself.   add vacancy at 5%.  PM at 10%.  This gets you to 25%.  

The maintenance/cap ex, insurance, misc (freak utility expense such as from a slab leak, portion of LLC, portion of tax person, portion of office expenses, portion of asset protection (umbrella insurance), etc) add up. do you really believe these items will not hit 15% recognizing a kitchen by itself is likely at least $50/month?

I believe few people have spent time accurately calculating expenses especially the maintenance/cap ex costs. I used to maintain a spreadsheet on each of our properties with expected life and cost of each item. As an item was replaced, the cost was and actual lifespan was used to update all similar entries. Turn over costs are often under estimated. They also often forget about the misc costs, but they add up significantly when the unit count is low. For example, the $800 LLC cost is significant if one rental unit, less so for 20 units.

there is no small unit count market in Ca where I consider 40% expense ratio to be conservative. in cheaper rent markets, areas with significant HOA or melo roos, 40% can be aggressive.

Originally posted by @Pavan Sandhu :

Every SFR in CA should have at least 1 ADU. I'd even go as far as to say you are losing money every month by not having an ADU on your property. These new laws are only in effect till 2024. What's stopping you from adding an Accessory Dwelling Unit to your property?

I disagree. While the new ADU laws are awesome for investors, as a personal residence, I would not appreciate having an ADU in all of my neighbors yards where many would come from garage conversions placing more parking on the street, tenants rather than homeowners in the neighborhood, and all the negatives that come with renters flooding a residential neighborhood. This is yet ANOTHER example of politicians ineptness to resolve huge issues like housing shortages. Similar to their resolution to water conservation, Los Angeles instituted rain harvesting tanks as a requirement to any new roof areas built. A complete waste of added costs to construction and they actually reduce the amount of rain water that will ultimately be used on the soft scape of the property. You do not resolve the housing shortage by targeting single family residence low density zoning areas. You tackle it by easing the ridiculous red tape for planning/permitting of new construction, increase density in multi family and higher density areas, and you provide easier process and tax credits and other financial benefits to assist developers in subdividing, zone changes (excluding single family residential neighborhoods).

As a developer, builder/contractor of ADU's, I support and welcome the new laws of course so this is a double edged sword. Of course I really love the ADU in the multi family space where you can build multiple ADU's on one lot as well as convert non livable space like car ports, breezeways, and storage areas to livable units so long as you meet fire egress.

As to Dan's comments, I agree that appraisals are not coming in to the cost to build in many cases (but not all cases) which can trap equity which is why I have specifically stated numerous times the importance of a long term hold (bare minimum of 5 years and 10 years better). That timeline will allow the cash flow to recoup the initial investment, allow time for more ADU comps to catch up to values invested, and also allow for natural market appreciation. After all, we are talking about CA here which is a top appreciation location for real estate you cant find in the midwest or even east coast (excluding NY).

I will also disagree with the operating expense ratio as well. The property taxes are NOT 10% of the rent and if you hit such a margin, then perhaps you should absolutely think twice on this strategy for that location. An average 450sf garage conversion to ADU costing $150k in a high rent rate areas like SO Cal would deliver ~$2500 monthly income. Your property taxes would not go up by the full $150k cost you put in. At an average 1.25% tax rate, you are looking at around 5% for tax increases. Property management should also not be 10% assuming this is an investment play where you are also leasing out the main house (or living in main house so managing your backyard rental can easily be done in house). Yes I understand the cost of time to manage yourself but that is not 10%. Dan is also assuming that the appraisals will not improve over the hold period which is likely not true. We are already seeing ADU appraisals coming in much more close to build costs but as many others mentioned, it is very area and appraiser dependent right now.

I think ADU additions/conversions are a very good investment here in So Cal, especially in areas like the San Fernando Valley where many of these older 1950's-1970's homes were built with detached garages and larger yards.

I think if we are ALL being honest, there are many who are bearish and bullish with ADUs in California.

In some instances, they make sense. In some cases they don't. Most, ADU investments need to be made in already dense areas that have a high desirability for renters. Also, existing infrastructure is a plus in the cost modeling for construction (value engineering).

As far as a long term investment, the jury is still out.  Until appraisals realign to this new norm of ADUs, I think we will continue to see this debate on both sides.

Originally posted by @Will Barnard :
Originally posted by @Pavan Sandhu:

Every SFR in CA should have at least 1 ADU. I'd even go as far as to say you are losing money every month by not having an ADU on your property. These new laws are only in effect till 2024. What's stopping you from adding an Accessory Dwelling Unit to your property?

I disagree. While the new ADU laws are awesome for investors, as a personal residence, I would not appreciate having an ADU in all of my neighbors yards where many would come from garage conversions placing more parking on the street, tenants rather than homeowners in the neighborhood, and all the negatives that come with renters flooding a residential neighborhood. This is yet ANOTHER example of politicians ineptness to resolve huge issues like housing shortages. Similar to their resolution to water conservation, Los Angeles instituted rain harvesting tanks as a requirement to any new roof areas built. A complete waste of added costs to construction and they actually reduce the amount of rain water that will ultimately be used on the soft scape of the property. You do not resolve the housing shortage by targeting single family residence low density zoning areas. You tackle it by easing the ridiculous red tape for planning/permitting of new construction, increase density in multi family and higher density areas, and you provide easier process and tax credits and other financial benefits to assist developers in subdividing, zone changes (excluding single family residential neighborhoods).

As a developer, builder/contractor of ADU's, I support and welcome the new laws of course so this is a double edged sword. Of course I really love the ADU in the multi family space where you can build multiple ADU's on one lot as well as convert non livable space like car ports, breezeways, and storage areas to livable units so long as you meet fire egress.

As to Dan's comments, I agree that appraisals are not coming in to the cost to build in many cases (but not all cases) which can trap equity which is why I have specifically stated numerous times the importance of a long term hold (bare minimum of 5 years and 10 years better). That timeline will allow the cash flow to recoup the initial investment, allow time for more ADU comps to catch up to values invested, and also allow for natural market appreciation. After all, we are talking about CA here which is a top appreciation location for real estate you cant find in the midwest or even east coast (excluding NY).

I will also disagree with the operating expense ratio as well. The property taxes are NOT 10% of the rent and if you hit such a margin, then perhaps you should absolutely think twice on this strategy for that location. An average 450sf garage conversion to ADU costing $150k in a high rent rate areas like SO Cal would deliver ~$2500 monthly income. Your property taxes would not go up by the full $150k cost you put in. At an average 1.25% tax rate, you are looking at around 5% for tax increases. Property management should also not be 10% assuming this is an investment play where you are also leasing out the main house (or living in main house so managing your backyard rental can easily be done in house). Yes I understand the cost of time to manage yourself but that is not 10%. Dan is also assuming that the appraisals will not improve over the hold period which is likely not true. We are already seeing ADU appraisals coming in much more close to build costs but as many others mentioned, it is very area and appraiser dependent right now.

I think ADU additions/conversions are a very good investment here in So Cal, especially in areas like the San Fernando Valley where many of these older 1950's-1970's homes were built with detached garages and larger yards.

First I agree with you SFH thoughts on ADUs. I share the same mixed sentiment. As a home owner I like the choice of having lower density options and do not like that I purchase with SFH with SFH zoning and now due to ADU laws my neighbors can convert the SFH into 3 units. As an investor (similar to you as a developer), I see and value the opportunity. I justify my interest in that if I do not do it someone else will, but that could simply be rationalizing it to appease my conscience. If the ADU rules for SFH did not exist, I would not shed a tear.

 >An average 450sf garage conversion to ADU costing $150k in a high rent rate areas like SO Cal would deliver ~$2500 monthly income. Your property taxes would not go up by the full $150k cost you put in. At an average 1.25% tax rate, you are looking at around 5% for tax increases.

I used a 1% rent ratio in my example (which I thought I indicated).  You are using 1.67% rent ratio.  It explains most of the difference.  The rest is likely because you rounded down as I show the percentage, using your numbers, as 6.25%.  At 1% rent ratio, the number I used is fairly accurate (depending on exactly the prop tax rate with bonds and other fees in your area).

The rent ratio will dictate the actual percentage of rent consumed by property tax.  Using Will's numbers the prop tax consumes 6.25% of the rent.  I did not specify an exact prop tax ratio, but a 1% rent ratio at 1.2% prop tax (slightly lower than Will used) results in the prop tax being 10% of the rent.

>Property management should also not be 10% assuming this is an investment play where you are also leasing out the main house (or living in main house so managing your backyard rental can easily be done in house). Yes I understand the cost of time to manage yourself but that is not 10%.  

I feel my time is worth at least 10% of the rent.  Professional PMs do not get rich on the fees they charge to manage, but make more from the contacts that result.  My point is 10% of rent really is not a wage that most investors would be enthused by.  I understand investors make this choice, I have made this choice as we self manage most of our units, but I recognize at 10% of rent this is probably my worst compensation for the level of effort of anything I do (we do it in part because I have issues giving up control).  If you feel your time is worth 5%, use 5%.  Recognize that if you use a PM, the costs will be ~10% if you have the PM do all of the tradition PM duties.  

I feel my time is worth more than 10%, but I cannot justify allocating more than what I could legitimately get a professional to manage for, so I use 10%.


>Dan is also assuming that the appraisals will not improve over the hold period which is likely not true. We are already seeing ADU appraisals coming in much more close to build costs but as many others mentioned, it is very area and appraiser dependent right now.

I would word it differently.  I do not assume that ADU appraisals will improve (meaning come in closer to hands off ADU addition costs) over time.  My approach is the safe approach which is what I try to always do in my pro formas and what I recommend all investors do in their pro formas.  Maybe ADU values will improve, but if the comps do not already justify the value, I would not assume that the comps in the future will give a closer to ADU addition costs valuation (I am not saying it will not, just that I would not recommend anyone assume this).

Assuming ADU values will improve places my pro forma at higher risk than I desire.


Originally posted by @Dan Heuschele :
Originally posted by @Jon Schwartz:
Originally posted by @Dan Heuschele:
40% expense ratio on small unit count (i.e. 2 in this case) is not conservative.  Have you figured a cap ex on a kitchen?  How about a water heater?  Add in maintenance, vacancy, I always include PM because I am either doing the role and deserve to be paid for my effort or I pay someone else to do it, taxes (note initial taxes are ~10% ratio on a 1% rent ratio (1.2% property tax rate), so 25% of the total of the 40% expense ratio is a certainty on a 1% rent ratio property (10% out of the 40%)), insurance, and Miscellaneous expenses.  You can challenge it, but there is a reason for the 50% rule.  I cut the 50% rule by 20% (20% of 50 is 10) for the high rent market, the reduction in costs of having 2 units co-located, etc.  I suspect the 40% expense ration will be fairly accurate in most high rent, low vacancy markets for the ADU.  For me to go lower than 40% expense ratio, I would need to analyze the property on an individual basis (does it have a yard, is it attached, how much hardscape, etc.).  I suspect that best case property will not be much lower than 40% expense ratio on a 2 unit count.

Dan, in Los Angeles, a 40% expense ratio on a newly built or newly converted ADU is insane.

In my neighborhood, a 400-sq-ft garage converted to a studio would easily rent for $1800/month. Underwriting $720/month for expenses is way, way off. Capex on the kitchen and water heater? Neither need to be replaced for a decade. What will it cost to replace them? Let's generously say $20K. That's $167/month in capex reserves -- and that's if you're holding the property in a decade.

ADUs are most needed, and most financially rewarding, in CA's high-density cities.

Love your posts, by the way!

Jon

>in Los Angeles, a 40% expense ratio on a newly built or newly converted ADU is insane.

I disagree.  

I would have twice the life span on the kitchen and therefore half the cost, but that is just one item ($50 to $70 per month for the kitchen).  Water heater I use 12.5 years ($10 to $12 per month).  There are a lot of items and their maintenance and cap ex add up.    Have you filled out a detailed cap ex worksheet?

The prop tax alone starts at ~10% expense ratio by itself.   add vacancy at 5%.  PM at 10%.  This gets you to 25%.  

The maintenance/cap ex, insurance, misc (freak utility expense such as from a slab leak, portion of LLC, portion of tax person, portion of office expenses, portion of asset protection (umbrella insurance), etc) add up. do you really believe these items will not hit 15% recognizing a kitchen by itself is likely at least $50/month?

I believe few people have spent time accurately calculating expenses especially the maintenance/cap ex costs. I used to maintain a spreadsheet on each of our properties with expected life and cost of each item. As an item was replaced, the cost was and actual lifespan was used to update all similar entries. Turn over costs are often under estimated. They also often forget about the misc costs, but they add up significantly when the unit count is low. For example, the $800 LLC cost is significant if one rental unit, less so for 20 units.

there is no small unit count market in Ca where I consider 40% expense ratio to be conservative. in cheaper rent markets, areas with significant HOA or melo roos, 40% can be aggressive.

Yeah... I appreciate your thoroughness, though I think you're over-accounting as relates to our ADU scenario.

A 10% property management allowance? I mean, I understand the logic behind accounting for your own time, but that 10% will never actually accrue (as opposed to capex, which will). Plus, in LA, property management rates are between 4-6%, even for smaller portfolios.

Also, LLC cost? Who's going to open an LLC to collect income from an ADU in the backyard? You can argue that having an LLC for the ADU is important for liability protection, but that's a canard.

You're also neglecting that a lot of these costs *don't* increase with the addition of an ADU. Adding an ADU doesn't require more personal office space, doesn't incur more cost from my accountant, doesn't increase my landscaping costs.

So no, I haven't done a thorough capex worksheet, so I can't *prove* that a 40% expense ratio on a newly built/converted ADU is too high. But I do think you're being too conservative in your considerations as regards a newly built/converted ADU in LA.

Best,

Jon

Originally posted by @Jon Schwartz :
Originally posted by @Dan Heuschele:
Originally posted by @Jon Schwartz:
Originally posted by @Dan Heuschele:
40% expense ratio on small unit count (i.e. 2 in this case) is not conservative.  Have you figured a cap ex on a kitchen?  How about a water heater?  Add in maintenance, vacancy, I always include PM because I am either doing the role and deserve to be paid for my effort or I pay someone else to do it, taxes (note initial taxes are ~10% ratio on a 1% rent ratio (1.2% property tax rate), so 25% of the total of the 40% expense ratio is a certainty on a 1% rent ratio property (10% out of the 40%)), insurance, and Miscellaneous expenses.  You can challenge it, but there is a reason for the 50% rule.  I cut the 50% rule by 20% (20% of 50 is 10) for the high rent market, the reduction in costs of having 2 units co-located, etc.  I suspect the 40% expense ration will be fairly accurate in most high rent, low vacancy markets for the ADU.  For me to go lower than 40% expense ratio, I would need to analyze the property on an individual basis (does it have a yard, is it attached, how much hardscape, etc.).  I suspect that best case property will not be much lower than 40% expense ratio on a 2 unit count.

Dan, in Los Angeles, a 40% expense ratio on a newly built or newly converted ADU is insane.

In my neighborhood, a 400-sq-ft garage converted to a studio would easily rent for $1800/month. Underwriting $720/month for expenses is way, way off. Capex on the kitchen and water heater? Neither need to be replaced for a decade. What will it cost to replace them? Let's generously say $20K. That's $167/month in capex reserves -- and that's if you're holding the property in a decade.

ADUs are most needed, and most financially rewarding, in CA's high-density cities.

Love your posts, by the way!

Jon

>in Los Angeles, a 40% expense ratio on a newly built or newly converted ADU is insane.

I disagree.  

I would have twice the life span on the kitchen and therefore half the cost, but that is just one item ($50 to $70 per month for the kitchen).  Water heater I use 12.5 years ($10 to $12 per month).  There are a lot of items and their maintenance and cap ex add up.    Have you filled out a detailed cap ex worksheet?

The prop tax alone starts at ~10% expense ratio by itself.   add vacancy at 5%.  PM at 10%.  This gets you to 25%.  

The maintenance/cap ex, insurance, misc (freak utility expense such as from a slab leak, portion of LLC, portion of tax person, portion of office expenses, portion of asset protection (umbrella insurance), etc) add up. do you really believe these items will not hit 15% recognizing a kitchen by itself is likely at least $50/month?

I believe few people have spent time accurately calculating expenses especially the maintenance/cap ex costs. I used to maintain a spreadsheet on each of our properties with expected life and cost of each item. As an item was replaced, the cost was and actual lifespan was used to update all similar entries. Turn over costs are often under estimated. They also often forget about the misc costs, but they add up significantly when the unit count is low. For example, the $800 LLC cost is significant if one rental unit, less so for 20 units.

there is no small unit count market in Ca where I consider 40% expense ratio to be conservative. in cheaper rent markets, areas with significant HOA or melo roos, 40% can be aggressive.

Yeah... I appreciate your thoroughness, though I think you're over-accounting as relates to our ADU scenario.

A 10% property management allowance? I mean, I understand the logic behind accounting for your own time, but that 10% will never actually accrue (as opposed to capex, which will). Plus, in LA, property management rates are between 4-6%, even for smaller portfolios.

Also, LLC cost? Who's going to open an LLC to collect income from an ADU in the backyard? You can argue that having an LLC for the ADU is important for liability protection, but that's a canard.

You're also neglecting that a lot of these costs *don't* increase with the addition of an ADU. Adding an ADU doesn't require more personal office space, doesn't incur more cost from my accountant, doesn't increase my landscaping costs.

So no, I haven't done a thorough capex worksheet, so I can't *prove* that a 40% expense ratio on a newly built/converted ADU is too high. But I do think you're being too conservative in your considerations as regards a newly built/converted ADU in LA.

Best,

Jon

 >property management rates are between 4-6%, even for smaller portfolios.

In San Diego I have seen base rates as low as 6% but they then charge for additional items (tenant placement, lease renewals, property inspections, service requests).  With the full costs It does not end up costing 6% (or less) and will end up close to 10%.  Do you know a PM that charges 6% or less that does not charge additional for tenant placement?  Lease resign?  Property inspections?

>LLC cost? Who's going to open an LLC to collect income from an ADU in the backyard? You can argue that having an LLC for the ADU is important for liability protection, but that's a canard. You're also neglecting that a lot of these costs *don't* increase with the addition of an ADU. Adding an ADU doesn't require more personal office space, doesn't incur more cost from my accountant, doesn't increase my landscaping costs.

I did not neglect it. It is why I stated the portion of those costs. For example lets say I have a umbrella policy that costs $1.5K year and I have 15 units. The cost per unit is $100/year or less than $10/month. We are similar for LLC as we have a management LLC and the $800/year is divided among the units and is small. I am unsure how you suggest these costs be depicted. I believe it is fair for them to be spread across the rental units. Regardless these are small (but do add up) compared to the maintenance/cap ex. Much of the 15% expense is maintenance/cap ex, but I do not believe maintenance/cap ex is primarily a function of the rent amount (vacancy for example directly relates to rent).

Do you believe a 40% cost ratio is conservative?  I do not but admit we allocate all expenditures which I think should be done.

My belief is high rent market with no HOA, no melo roos, no significant deferred maintenance may have 40% expense ratio (not conservative). Most medium rent markets, or high rent markets with melo roos or HOA, may have a 50% expense ratio (the 50% rule). Low rent markets or properties with a lot of deferred maintenance will exceed the 50% expense ratio. I do not believe a complete unit that rents for $500/month can maintain an expense ratio of 50% or below. The maintenance/cap ex will consume too much of the rent.

I really think that the positives/negatives have to be evaluated for each ADU project. IMO, there is a big difference for those with short term vs long term goals. I think that there are more risks for those that are looking for a quick return on their investment than those of us who are going for long term cash flow and have substantial equity to cover any costs.

I'm adding a detached ADU to my personal Duplex. I could have added two 1200 sq ft detached ADUs, but I have opted to put a single story 2+2 950 sq ft ADU with about 400 sq ft of decking for the unit (under contract) . I didn't want to impact the views of the second story.. My affluent neighborhood primarily consists of single family homes. It is low density and less than 100 yards from public transit..The budget for the ADU has been dictated by the neighborhood and my target renter --- the single person or couple who do not blink at $5K+ per month now for rent. I mainly look at the ADU as another revenue stream as well as a source for more deductions. At some point, I may move into it to renovate my unit or the other unit. The rent currently covers the building's expenses. I was given estimates of $450 - $750 per sq ft to build the ADU From my very novice assessment, my ADU only makes sense for a long term investment for my high rent neighborhood. Since I started my research five months ago. Ground has been broken for two new spec homes with attached ADUs a few blocks from me and they are already in escrow.

Adus are becoming the standard for new builds in the Bay Area to go beyond standard lot coverage ratio and FAR (adu is exempted for 800 sqft in most cities). At the same time, sb9 and sb10 are signed into law. Multi-units are going to be so common on single family lots (in fact there will be no sfh zoning). The debate around Adu is largely over. Let's move on.

Originally posted by @Chen Zhou :

Adus are becoming the standard for new builds in the Bay Area to go beyond standard lot coverage ratio and FAR (adu is exempted for 800 sqft in most cities). At the same time, sb9 and sb10 are signed into law. Multi-units are going to be so common on single family lots (in fact there will be no sfh zoning). The debate around Adu is largely over. Let's move on.

 Sb9 requires 3 years occupancy which will eliminate it as an option for non house hackers.  Sb10 allows local jurisdictions to enforce stricter zoning which will be the case in most jurisdictions. 

For the non house hacker, ADUs may still be the best option.

I suspect there are many house hacking investors that added an ADU that wish they had waited. The split lot would result in 2nd lot being value similar to primary lot and if desired they could add 2 units per lot. SB9 does require commitment to reside in property for 3 years from approval. This will eliminate its use for many investors who do not want to house hack.

I Agree that:  

I think ADU additions/conversions are a very good investment here in So Cal, especially in areas like the San Fernando Valley where many of these older 1950's-1970's homes were built with detached garages and larger yards.

Originally posted by @Will Barnard :
Originally posted by @Pavan Sandhu:

Every SFR in CA should have at least 1 ADU. I'd even go as far as to say you are losing money every month by not having an ADU on your property. These new laws are only in effect till 2024. What's stopping you from adding an Accessory Dwelling Unit to your property?

I disagree. While the new ADU laws are awesome for investors, as a personal residence, I would not appreciate having an ADU in all of my neighbors yards where many would come from garage conversions placing more parking on the street, tenants rather than homeowners in the neighborhood, and all the negatives that come with renters flooding a residential neighborhood. This is yet ANOTHER example of politicians ineptness to resolve huge issues like housing shortages. Similar to their resolution to water conservation, Los Angeles instituted rain harvesting tanks as a requirement to any new roof areas built. A complete waste of added costs to construction and they actually reduce the amount of rain water that will ultimately be used on the soft scape of the property. You do not resolve the housing shortage by targeting single family residence low density zoning areas. You tackle it by easing the ridiculous red tape for planning/permitting of new construction, increase density in multi family and higher density areas, and you provide easier process and tax credits and other financial benefits to assist developers in subdividing, zone changes (excluding single family residential neighborhoods).

As a developer, builder/contractor of ADU's, I support and welcome the new laws of course so this is a double edged sword. Of course I really love the ADU in the multi family space where you can build multiple ADU's on one lot as well as convert non livable space like car ports, breezeways, and storage areas to livable units so long as you meet fire egress.

As to Dan's comments, I agree that appraisals are not coming in to the cost to build in many cases (but not all cases) which can trap equity which is why I have specifically stated numerous times the importance of a long term hold (bare minimum of 5 years and 10 years better). That timeline will allow the cash flow to recoup the initial investment, allow time for more ADU comps to catch up to values invested, and also allow for natural market appreciation. After all, we are talking about CA here which is a top appreciation location for real estate you cant find in the midwest or even east coast (excluding NY).

I will also disagree with the operating expense ratio as well. The property taxes are NOT 10% of the rent and if you hit such a margin, then perhaps you should absolutely think twice on this strategy for that location. An average 450sf garage conversion to ADU costing $150k in a high rent rate areas like SO Cal would deliver ~$2500 monthly income. Your property taxes would not go up by the full $150k cost you put in. At an average 1.25% tax rate, you are looking at around 5% for tax increases. Property management should also not be 10% assuming this is an investment play where you are also leasing out the main house (or living in main house so managing your backyard rental can easily be done in house). Yes I understand the cost of time to manage yourself but that is not 10%. Dan is also assuming that the appraisals will not improve over the hold period which is likely not true. We are already seeing ADU appraisals coming in much more close to build costs but as many others mentioned, it is very area and appraiser dependent right now.

I think ADU additions/conversions are a very good investment here in So Cal, especially in areas like the San Fernando Valley where many of these older 1950's-1970's homes were built with detached garages and larger yards.